FINANCE CHAPTER 13: EQUITY VALUATION
Terms in this set (32)
What is equity valuation?
- Figuring out what they're worth & projecting how their prices will change.
- You can measure the stock itself using any of a number of equity valuation models.
Most of the valuation models use the notion of:
- Valuation by comparables: Where they look at the relationship between price and the determinants of value
- Analysts can also use valuation by comparables approach where the analyst identifies companies similar to the one they are trying to value. They judge whether the stock is underpriced or overpriced by comparing standardized measures (e.g. P/E ratio) across companies.
What are the different types of value of a firm?
- Book value
- Market value
- Liquidation value
- Intrinsic value
What is book value?
-Definition: The net worth of the company according to a firm's balance sheet
-Book values represent an accountant's view of the original cost of acquiring assets, with an adjustment for depreciation.
-While financial analysts use information from financial statements, they are more interested in forward-looking measures of the firm's value.
How is book value obtained?
= Assets - Liability
What is liquidation value?
-Definition: is the net amount that can be realized by selling the assets of a firm and paying off the debt.
-It provides a "floor" for the value of equity: If the market price of equity drops below the liquidation value of the firm, the firm becomes attractive as a takeover target.
-This type of value is relevant for a corporate raider that considers taking over the firm and liquidating its assets. It can also be useful to analysts looking for potential takeover targets
What is market value?
-Market value is the difference between the current market value of assets and liabilities.
-The prices per share that you see on stock exchanges do not reflect book values, they reflect the market value of the shareholder's equity investment
What is market capitalization?
- Definition: is the total market value of the shares outstanding of a publicly traded company
= price per share x the number of shares outstanding.
What do fundamental analysts look for?
-Look for underpriced securities.
- He does not assume that market values are correct.
-Using a valuation model (there are many), he computes the intrinsic value of the firm to assess whether the stock is a buy or a sell.
If fundamental Analysts see that the intrinsic value is greater than market price he will..
If fundamental Analysts see that the intrinsic value is less than market prince he will..
What is the equation for price-earnings multiple?
Stock Value=Forecasted P/E ratio×Forecasted earnings
How do sell-side analysts see the value of the firm?
Sell-side analysts express their view of the value of the firm as a price target, which is typically the share price that they expect in one year.
What does a high P/E ratio mean in relative valuation?
- Either it can be a warning sign of overpricing or can reflect greater growth for the firm
What do some analysts do to adjust growth in relative valuation?
- To adjust for growth, some analysts use the PEG (price per earnings to growth) ratio.
What other ratios may analysts use other than the P/E ratio?
- Price-to-cash-flow (can address concerns that earnings are manipulated by accounting practices)
- Price-to-sales (useful for start-up firms with no earnings - can be affected by margins)
What is Discounted Cash Flow(DCF)?
With a discounted cash flow (DCF) approach, the analyst projects the cash flows of the firm and discounts them with a risk-adjusted discount rate k.
The two types of DCF approaches are?
dividend discount models (DDM) and free cash flows (FCF) models.
Two approaches to project cash flows over time in Discounted Cash Flow?
- Project cash flows in perpetuity Can be hard to be accurate after a few years
- Project cash flows for a few years and assume that stock is sold at a terminal value Valuations can be very sensitive to terminal value assumption
What is the dividend discount model (DDM)
Definition: the value of the stock is equal to the present value of the stock's future dividends, discounted at the market capitalization rate k
DDM: Two stage growth model
Assume that dividends grow at a constant rate g_1 for a number of years, and then at a rate g_2 afterwards.
What are free cash flows?
Definition: which are cash flows available to the firm or the equityholders, net of capital expenditures
The FCF approach has two variations:
1. FCFF (Free Cash Flows to the Firm):
2. FCFE (Free Cash Flows to Equityholders):
Free Cash flows to the firm (FCFF)
-Use all FCFs
-Deduct the value of debt from the value of the FCFC's
-use WACC as a discount rate
Free Cash Flows to Equityholders (FCFF)
- Deduct interest payments and add increase in net debt from the FCFFs.
- Use cost of equity as a discount rate.
The constant-growth dividend discount model (DDM) can be used only when
the growth rate is less than the required return
You want to earn a return of 10% on each of two stocks, A and B. Each of the stocks is expected to pay a dividend of $4 in the upcoming year. The expected growth rate of dividends is 6% for stock A and 5% for stock B. Using the constant-growth DDM, the intrinsic value of stock
will be higher than the intrinsic value of stock B
Everything else equal, which variable is negatively related to the intrinsic value of a company?
Which valuation measures is often used to compare firms that have NO earnings?
You are valuing a company that is not currently paying dividends. Which method would be the most appropriate?
Free Cash Flow valuation
calculating P/E ratio
- Ex: if P/E ratio of 15 can be interpreted as: "it takes 15 years to get back your investment if earnings don't change".
calculating PEG ratio
= P/E ratio / forecasted growth rate x100
. Rules of thumb:
- where fairly priced companies should have a PEG ratio around 1. (Not theoretically motivated.)